[House Built on Debt] ① Collapsing 'Giant Cartel'... The Naked Truth of Korean Real Estate PF

'Lack of Risk Diversification Mechanisms Amid "Transition from Construction Companies to Financial Firms"
Insufficient Evaluation Capability of Financial Companies for PF Loan Project Feasibility
Excessive Fees Charged by Securities Firms on Real Estate PF Loans Also Problematic

Editor's NoteThe aftermath of Taeyoung Construction's workout (corporate restructuring) application is shaking not only the construction industry but also South Korea's financial sector and capital markets. The decisive cause of Taeyoung Construction's workout application is excessive project financing (PF) guarantees. In an attempt to increase order volumes, PF guarantees were recklessly issued, and as the real estate market froze faster than expected, projects were delayed, making it impossible to repay principal and interest. As real estate PF defaults materialized, not only the secondary financial sector such as savings banks, capital companies, and securities firms but also the primary financial sector froze. Thirteen years ago, during the savings bank crisis, the issue was considered limited to mid-sized construction companies focused on housing projects and savings banks, but the recent PF default crisis has a much broader impact. Secondary financial institutions such as Saemaeul Geumgo, capital companies, securities firms, and savings banks actively participated in real estate PF loans, and trust companies also participated under the condition of performance guarantees for mid-sized construction companies with low credit ratings, spreading PF loan risks throughout the financial sector. With Taeyoung Construction, ranked 16th in contract ranking, shaking, there are concerns about a chain bankruptcy of mid-sized construction companies that increased orders and PF loans during the real estate market upswing. Real estate PF defaults, which threaten our economy whenever they resurface, are examined through the opinions of construction, finance, and capital market experts to find fundamental causes and constructive alternatives to prevent recurrence.

The Collapsing 'Real Estate Cartel'... The Distorted Structure of Korean Real Estate PF

"Small-scale developers with local government networks contract land first with only deposits and no land value, then approach construction companies. If the construction company provides a guarantee, they can get a bridge loan. Bridge loans are mainly issued by securities firms. Securities firms do not hold these loans themselves but sell them down (resell) to secondary financial institutions such as savings banks, credit unions, and Saemaeul Geumgo. Developers create one-year bridge loans, finalize designs and business plans, and then proceed to get loans from primary financial institutions. They use those funds to repay the bridge loans first and then build the houses. When the real estate market is good and sales go well, developers can hit the jackpot without initial capital, but when the market worsens, who takes responsibility? Developers lack the capacity to absorb losses, so the responsibility shifts entirely to the construction companies that provided guarantees. There is also a lot of blind money in the middle. Real estate trust companies earn tens of billions sitting quietly while providing payment guarantees. If there are 100 projects, they earn hundreds of billions just sitting. Securities firms also take tens of billions in fees per PF loan. A massive real estate cartel has formed. Now, the damage from this money feast is falling squarely on the public."

[Image source=Yonhap News]

A senior financial sector figure who once headed a commercial bank pointed out that South Korea's real estate project financing (PF) structure is a 'massive real estate cartel.' Houses built on debt are collapsing. Experts point out that Korea's real estate PF defaults are a structural failure caused by small-scale developers, excessive competition between developers and construction companies, lack of third-party risk dispersion mechanisms, and lax monitoring by authorities.

In Korea, developers and constructors are separated. The developer, the project principal, buys the land and decides what to build. Sometimes they also handle design and sales. The constructor is the construction company that carries out the work as the developer wishes. For example, a union formed for reconstruction is the developer, and the company building the structure is the constructor. The separation of developer and constructor emerged during the IMF financial crisis. Previously, large construction companies bought land, built buildings, and handled sales themselves. However, since land acquisition costs were identified as a cause of increased debt ratios for construction companies, developers emerged to handle land acquisition, permits, sales management, and contract management. Construction companies can avoid financial deterioration due to land acquisition costs and proceed with construction through this system.

However, for developers who are not large corporations, purchasing land worth hundreds of millions or billions of won for construction is a heavy burden. Therefore, large construction companies as constructors provide payment guarantees to enable developers to acquire land.

Real estate PF defaults often occur because construction companies excessively provide payment guarantees for developers conducting construction. Due to a downturn in the construction market, projects become insolvent, and constructors must repay loans borrowed by developers. Real estate PF is a financial technique that raises funds based on future sales and rental income from real estate development projects. Bridge loans are typically used to raise initial funds for land acquisition before construction starts. Most developers, who are small-scale with low credit ratings, borrow money at high interest rates from secondary financial institutions such as savings banks and capital companies. Using these funds, developers buy land, obtain permits, and complete later-stage tasks like selecting constructors, then secure lower-interest loans from primary financial institutions. This is called the main PF loan. At this stage, companies usually repay the high-interest bridge loans first.

Here lies the characteristic and weak link of Korean-style PF. Small-scale developers engage in speculative loans, and construction companies, eager to secure projects during overheated real estate markets, bear excessive payment guarantee responsibilities. There is no third-party mechanism to break the risk chain in the middle. Developers, financial institutions, and construction companies become sequentially affected by insolvency during economic downturns. The risk transfer is easy in this structure. The separation of developer and constructor, intended to reduce construction companies' debt ratios, ironically pushed them into a more dangerous position.

Korean developers invest only 5-10% of the total project cost as equity capital, and the rest of the project cost (land and construction costs) is entirely financed through PF loans and sales proceeds. This is because most developers are small-scale. Currently, a real estate development company (developer) can be established with just 30 million won in capital.

An industry expert said, "The construction market is saturated with competition in the construction sector, so construction companies have tended to accept projects as long as developers have land. The risk started with developers having weak capital and was passed on to the developers themselves."

Project Financing Without a Project

In advanced countries like the United States and Japan, real estate development projects are initiated by entities with substantial equity capital and funds raised from various investors, who purchase land and complete project permits before starting PF financing. Only construction and other project costs are financed through PF loans. Various capital sources such as funds, REITs, pension funds, and private investment associations are well developed. Most developers are large corporations, making capital raising easier.

An industry expert said, "Overseas developers are mostly large companies, but domestic developers only purchase land and lack the ability to manage the project. So they secure land first, subcontract construction to constructors, and effectively let constructors manage the project."

He explained, "Looking at the history of Korean real estate PF, initially, the government purchased land and private entities constructed buildings as private investment projects, but as the market shifted to pure private participation, risks were borne entirely by private participants, turning it into a kind of speculative finance."

Another critical problem is that financial institutions lending money have weak capabilities to assess the project's viability during PF loan screening. Instead of judging based on project feasibility, they rely on the construction company's credit rating and guarantees. Also, when seeing a list of other participating institutions in PF, if large institutions participate, project concentration occurs. The decision for primary financial institution loans is based more on which high-credit construction company provides guarantees and who participates than on the project itself.

A representative from the real estate trust industry said, "Financial companies should conduct detailed project assessments when deciding on PF participation, but Korean financial institutions, including banks, have not moved beyond a pawnshop level."

He added, "Even after the IMF foreign exchange crisis, only appearances changed. When someone says 'who participated' or 'which PF is doing well,' they still flock in groups, showing backward behavior. Financial institutions should independently assess and lend to projects with viability even in recessions and reject those with low profitability even in booms, but they lack such judgment and just follow the crowd."

Bridge Loans at Their Limit... Missed 'Opportunity' for Self-Correction Despite One-Year Grace Period

During the past low-interest real estate boom, PF loans increased rapidly without proper screening standards, reaching their limit amid prolonged high interest rates.

The outstanding balance of real estate PF loans in the financial sector swelled to 112.9 trillion won at the end of 2021, 130.3 trillion won at the end of 2022, and 134.3 trillion won by the end of September 2023. During the same period, real estate PF delinquency rates rose from 0.37% to 1.19% and then to 2.42%.

Experts analyze that although the government provided about a one-year grace period to encourage project operators to restructure insolvent projects, it failed to achieve effectiveness. Leaving it solely to individual operators resulted in inadequate restructuring of insolvent projects.

Currently, continuing the PF market through maturity extensions carries significant risks. Last year, the Legoland incident brought PF-related issues to light, and there was public opinion, especially among some securities firms, for phased restructuring, but it did not materialize.

Professor Yang Jun-mo of Yonsei University's Department of Economics said, "Liquidity was supplied for about a year to buy time, but leaving it to developers and individual construction companies resulted in no proper restructuring. Everyone considered their projects as 'treasures,' so they couldn't sell at lower prices and kept extending loans, leading to this situation."

Professor Yang added, "For projects that proceeded somewhat aggressively, led by Taeyoung, this should be seen as a signal that restructuring is now necessary. The government should encourage some adjustments rather than continuously pumping liquidity, allowing losses to be cleared and accurate reevaluation to take place."

Failing to Prevent Economic Crisis, 'Snowballing' Insolvency... 'Guarantees' as the Boy Who Cried Wolf

From the perspective of primary financial institutions, a more objective sense of crisis is felt. A commercial bank PF finance officer said, "Bridge loans have been in a mismatch state, not transitioning to main PF loans, but the government kept extending and reducing interest rates to prevent a collapse, and a year has passed. What barely held on is now really starting to break." He added, "The government intervened actively against market logic to prevent collapse, but actually, it should have started breaking down gradually one or two years ago."

Because the economic impact of large project insolvencies is enormous, the government has actively intervened to prevent collapse, but now it is insufficient. The official said, "In trying to save large companies, small companies also survived, and eventually, insolvency snowballed." He added, "PF structures are complex, and if you add footnotes and change conditions, some figures are excluded, but there is so much hidden insolvency that financial authorities find it difficult to aggregate the market. After Taeyoung Construction's collapse, banks are reanalyzing their exposure to construction companies and view this crisis very seriously. Now, even with guarantees, they don't trust them and have closed the loan doors."